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Don’t Worry or Fret

The FOMC when they met
Explained that there’s no problem yet
Regarding inflation
Or acceleration
Of wages, don’t worry or fret

In fact, what they seemed to imply
Was prices must rise really high
Before they will worry
As they’re in no hurry
To wave the recov’ry bye-bye.

The FOMC left rates on hold, as was universally expected, but the statement changes were a bit harder to parse. On the one hand they recognized that inflation was moving higher, although they were nonplussed about inflation expectations despite those seeming to rise as well. On the other hand, they had a mixed view of economic growth, highlighting strength in investment but recognizing that consumption has ebbed slightly. Arguably, the biggest deal was that they mentioned, not once but twice, that their inflation goal is symmetric, which was read to mean that they are perfectly comfortable with inflation running above 2.0% for some time. Of course, the question is just how far above 2.0% inflation will have to go before they become uncomfortable. The market response was actually quite interesting as the initial move in equity markets was higher but then stocks gave back those gains and then some and were lower overall on the day. The dollar, meanwhile, initially sold off on the report, but then rebounded sharply to trade to its highest point this year. While it has not been able to maintain those gains thus far this morning, the trend remains clearly in the dollar’s favor for the time being.

With this meeting out of the way, the market is now 100% convinced that they will raise rates in June, and the punditry, if not the markets, are pretty certain that they will not act again before September. This idea of only adjusting policy at press conference meetings has become deeply ingrained in analyst thinking. And I guess as long as the Fed forecasts of the trajectory of growth and inflation are correct, that is a reasonable expectation. The problem with this theory is that the Fed is notoriously awful at forecasting growth and inflation. It is with that in mind that I cannot help but look at the trend in inflation, which remains sharply higher, and think that by September they are going to figure out that they are falling behind the curve and will need to step up the pace of policy tightening. If the trend is your friend, which remains a longstanding markets mantra, then current trends are pointing to higher inflation, higher interest rates and a higher dollar as we go forward. We will need to see some pretty dramatic changes in the underlying economics in order to break these trends.

Turning our attention to the rest of the world, this morning the ECB was met with weaker than expected CPI data, exactly what they don’t want to see if they are keen to end their QE program. The April reading of 1.2% continues the trend seen since January 2017, when it briefly touched 2.0%. And remember, this is ongoing despite rising oil prices, which has one of the biggest impacts on inflation and inflation expectations. The point is the hawks are watching their case disintegrate in front of their eyes and are going to be hard-pressed to convince the rest of the council that ending QE is urgent. As I have watched the Eurozone data unfold, it is becoming clearer every day that not only is QE not going to end in September, but it is not even going to be reduced. For all the euro bulls out there, this is another nail in the coffin.

Meanwhile, the UK is feeling the pressure as well as the Services PMI data was released at a weaker than expected 52.8, with the trend since Q4 clearly heading down. It is no surprise that the idea of a BOE hike next week has been priced out of the market. Adding to the pressure on the UK economy is the ongoing political wrangling over how to deal with Brexit. It appears that PM May is slowly losing her grip on power with the hardliners in her cabinet unwilling to accept a kluge solution for the Irish border issue and very clearly willing to leave the Customs Union accordingly. While the pound is down more than 5% from its recent peak in mid-April, it remains 13% above the lows seen in the wake of the initial Brexit vote. I would contend that the market has become far too accepting that a good deal will result from the negotiations, and thus have not discounted a more dramatic outcome. Combining the ever tightening US policy action with a more negative Brexit outcome leads me to believe that a move back toward 1.25 is quite viable before the year ends.

In the EMG space, the dollar, though slightly softer this morning, is broadly higher this year. There have been numerous articles describing the key issues for these currencies which essentially boil down to rising US rates reduce the attractiveness of emerging markets as an investment opportunity and so result in position adjustments. This pressures EMG currencies lower, which simply adds to the vicious cycle of negativity. The resulting weaker currency pressures EMG companies, who have borrowed in USD (apparently to the tune of ~$3 trillion) because it takes more local currency to repay those loans, thus negatively impacting their profits and driving a further exodus from those securities. You can see how this might get out of control if some exogenous factor arose, but even in its current form, it is very difficult to make the case that this cycle will end soon. That is even truer if the Fed is forced to increase the pace of rate hikes. In the end, it is difficult to look at this bloc of currencies and see anything other than downside for the summer at least.

As for today, we have another rush of data as follows: Initial Claims (exp 224K); Trade Balance (-$49.9B); Nonfarm Productivity (0.9%) and Unit Labor Costs (3.0%) all at 8:30. Then at 10:00 we see Factory Orders (1.3%) and ISM Non-Manufacturing (58.4). To me, the productivity data will be the most interesting. There has been much discussion of the mysterious weakness in productivity data in the US over the past decade, and it is clear that weakness has been one of the drivers of the much weak recovery that has occurred during that time. Former Fed Chair Yellen recently highlighted that as long as wage growth increased at a pace of productivity plus 2%, there would be limited pressure for higher inflation. However, given the dearth of productivity growth, which has averaged below 1% for quite a long time, and given that wages are growing at least at 2.8% as measured, it seems that we are on the cusp of a potential breakout on the inflation side. This is just another indicator to watch in order to follow the inflation trend.

I know I have been harping on inflation a lot lately, but that is only because I see it is the great unknown in market behavior. Given how long it has been since high inflation has plagued the US, there are many traders and investors who have never seen markets respond to this situation. What I want to reiterate is that it is a very real risk to market behavior, and especially to the FX market. There has been nothing in the data that indicates inflation is just going to reach 2.0% and stabilize there. Rather, history shows that it is far more likely to continue higher and force the Fed’s hand. And that is likely to happen sooner than most people expect. It is just another reason that I like the dollar to continue to outperform as the Fed responds while other central banks have a very different economic picture to evaluate.